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Thursday, March 13, 2014

Rolls Hubris Hypothesis and Acquiring Firm Returns

I've heard management professors and some consultants throw around comments like "Seventy percent of all acquisitions fail." I don't believe it and the statistical evidence doesn't support that claim. True, there is a lot of evidence that suggests bidders break even or lose a few percent at the announcement of a bid. The combined returns to bidders and targets, appropriately weighted for size, are positive. The typical deal creates value. What I might believe is that 70 percent (or more) of mergers fail to realize their potential. But that is typically a problem of integration and the subject of other posts. So what do we make of the continuing story that bidders tend to lose or break even? After all, bidding activity continues to be quite popular (even if currently dampened). There are many explanations in the literature to explain bidder returns. Today, I will mention two.The first is the possibility that we, as researchers, are not measuring returns correctly. In a recent paper published in the Review of Financial Studies we present evidence that the typically measured bidder return doesn't adjust for anticipation. When returns are measured correctly bidder returns are positive. See (Anticipation, Acquisitions and Bidder Returns.)

In an efficient market, the value of a firm's shares are priced correctly. Why would bidders typically add 20-40% to the market price in their bids? Why would bidders pay more than this? The obvious, and always cited reason is synergies. Synergies, of course, can be easily overestimated and in other posts we note that you should always challenge the assumption of synergies. Why are they available to your firm and to no one else? Another reason to explain high bid prices is behavioral - the hubris factor. Roll (1986) was the first to point this out in the finance literature. Anyone who has bid for an object on Ebay understands that it is easy to overpay, to go beyond the rational limits we might set in advance on our bids. We get caught up in deal fever or a desire to 'win' regardless of price. The same behavior must certainly be true of at least some acquiring managments. One can imagine the psychological pressures on management in certain bidding wars. Multiple sides express multiple views with many unkind words and suggestions. If psychological factors lead bidders to go beyond pre-determined boundaries (or equivalently if management directly or indirectly causes their own analysts to overestimate the gains to mergers in setting those boundaries) shareholders lose. As we have noted, some of the best deals are those not attempted or in this case, not completed. One of the best illustrations of the hubris phenomena are found in the words of Warren Buffett, quoted in a previous post,"Many managers were apparently over-exposed in impressionable childhood years to thestory in which the imprisoned, handsome prince is released from the toad's body by a kissfrom the beautiful princess. Consequently, they are certain that the managerial kiss willdo wonders for the profitability of the target company. Such optimism is essential.Absent that rosy view, why else should the shareholders of company A want to own aninterest in B at a takeover cost that is two times the market price they'd pay if they madedirect purchases on their own? In other words investors can always buy toads at thegoing price for toads. If investors instead bankroll princesses who wish to pay doublefor the right to kiss the toad, those kisses better pack some real dynamite. We've observedmany kisses, but very few miracles. Nevertheless, many managerial princesses remainserenely confident about the future potency of their kisses, even after their corporatebackyards are knee-deep in unresponsive toads." (Warren Buffett in the 1981 Berkshire Hathaway Annual Report)We'll continue this discussion in two ways in the future. One will be through an analysis of other factors related to bid premia and to bidding and acquiring returns. A second avenue of analysis will continue to explore the role of behavioral factors in mergers and acquisitions.All the best,Ralph

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About MergerProf

In addition to their day jobs, Joe and Ralph teach acquisition finance at the Amsterdam Institute of Finance. This blog was created in the summer of 2012 as a tool for those interested in acquisition finance and related material. Admittedly, we define related material broadly to include mergers, private equity, banking, governance, deal making and, well, finance in general. We hope you will enjoy and contribute, critiquing, expanding and providing your own examples related to the posts. We encourage you to join us in this adventure and, for some of you, to see you in Amsterdam, New York or Philadelphia.